succession planning, employee owned, the value of the business, the acquisition game

There are a lot of myths around succession planning, from the young staff who think the business will be given to them, to the older business owner who thinks their business is going to be bought from them. Let’s look at a few.

Giving Away Shares

One version of succession planning is for the retiring shareholder(s) to give shares to the next generation. In this way, the theory goes, they will incentivise and lock in younger staff who will one day take over the business and enable the older shareholders to leave yet still continue to participate in profit.

The major drawback here is tax. HMRC will view such a gift of shares as coming about only due to the employment of the individual. Which means they will treat it as income, and tax accordingly. So a ‘gift’ of shares (which cannot be exchanged for cash) would result in a very large payment of tax – to be paid in cash!

For this reason the gifting of shares is rarely an option.

Skin In The Game Is Essential

The Management Buy Out is a common method for succession planning. This can, of course, work, but comes with baggage.

For example, not everyone will be able to buy in, and those that can access the cash or provide their house as security for a loan might not always be the ones the owner would want to be in charge. The ‘have and have nots’ culture can also be destructive.

Probably the biggest myth, however, is that having something to lose – such as one’s house, which has been required as security – provides motivation. It can do – however it can also result in exactly the opposite (more on this in this blog).

The Value Of The Business

One of the great clichés about privately owned businesses is that a business is only worth what someone is willing to pay for it.

Or, as a corporate finance friend of mine once put it, the single biggest reason why businesses fail to sell is vendor expectation.

This is especially true if the vendor is the founder of the business. If a business has been everything to you, your passion and your obsession, you don’t want to let it go for less that you think it is worth. Trouble is, anyone wanting to buy your business wants to be able to see an increase in value, and this is a lot easier if they can buy it at a discount.

The Actual Value Of The Business – The Acquisition Game

There is very often a significant difference between the amount of money that a person is first offered for their business and the amount they end up with in their bank account.

Here is how the game is played:

  1. Purchasing company makes an offer. It is pitched at a level that matches the owners (often inflated) value of their business
  2. Owner goes home and discusses with family. Maybe with staff. Everyone agrees this is the one, this time it could really work
  3. Heads of terms are signed. At last the owner is going to be able to release value, perhaps move on in life
  4. Purchaser undertakes due diligence (a detailed investigation into the business). The offer is reduced based on the findings
  5. Warranties are required and/or the offer structures moves to less up front and more over an earn out period.
  6. Owner, committed in their mind to moving on, reluctantly agrees to the new deal
  7. An amount is paid up front.
  8. Further amounts are paid over the earn out period, but less that the owner expected due to the warranties

The actual amount of money the owner ends up with in their bank account is often considerably less than the initial amount they accepted.

Don’t Believe All That You Read

In step 1 above, the vendor already had an expectation of the value of their business. Where did this come from?

It may have come from an email from an acquiring company headed ‘Release The Value Of Your Business’ and quoting some multiple or another. So they’ve no reason to quote only the higher, initial figure, have they?!

Perhaps it came from experience of a local firm, a buddy who sold their firm. You’ll hear the value at the time of sale, not the total received at the end of the earn out. And that value now will most likely be the initial offer, before due diligence.

Businesses Sell For Current Profit, Not Potential

There are always exceptions to these rules, but by far the norm is that someone will want to buy a business because of the potential increase in value that it may provide. This can be another reason why a vendor values their business more than a purchaser.

In the financial advice sector, for example, a business that is charging 1% pa on assets may be more attractive to buy than a business charging 0.5%. This seems daft, but the purchaser of the 0.5% business will pay according to the lower income multiple, but will then increase charges to 1% and increases profit.

Conclusion

Many of these myths are perpetuated by people who have a vested interest in businesses being sold. The M&A (mergers and acquisitions) market in the UK is huge.

In Germany, however, it is tiny. The sale of a business, either to a third party or to a management team, is not an inevitability.

So when a business owner considers the independent valuation offered on sale to an EOT and compares it to the offer make from a large acquiring business, be aware that you are not necessarily comparing like with like.

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